The No-Reform Tax Reform: Union Pacific Case Study

Kansas City, USA - Switching of engines and trains at a railroad yard in Kansas City.

Being surprised is anathema to a stock analyst. Still, looking through Union Pacific’s third quarter financial statements gave me a shock. For Union Pacific bulls, I discovered a positive shock; for U.S. taxpayers and citizens, I found a negative one.

The Republican-controlled Congress pushed through a hasty “Tax Reform” bill late in December of last year with the argument that the high statutory income tax rate for U.S. corporations put them at a competitive disadvantage to companies domiciled in low-tax countries. Certainly, there were several anecdotes – especially pharmaceutical manufacturers and conglomerates that used “corporate inversion” strategies to move headquarters overseas – to which lawmakers could point.

A collection of anecdotes does not, however, prove a point. Statistically, no matter how high the statutory rate was for U.S. corporations, the effective rate paid – after various legal deductions and tax shelters were used – was on par with corporations worldwide: on the order of 20%.

Union Pacific serves as a perfect case in point. The company has some interests in Mexican railroads, but the vast majority of its revenues and profits are generated in the United States. Because the domestic share of its profits is and always has been so high, UP had been unable to squirrel away untaxed profits overseas like Apple and other tech firms were infamous for doing.

Long story short, if any company would have paid something close to the statutory rate, it would have been Union Pacific. Here is a graph of what Union Pacific actually paid in taxes through the 2016 fiscal year.

Figure 1. Source: Company Statements, Framework Investing Analysis

FrameworkInvesting.com

Over this period, Union Pacific’s actual tax rate averaged 20% as it took advantage – in a completely legal and aboveboard way – deductions built into our convoluted system of corporate taxation. Were the company to have paid the statutory rate, it would have paid on the order of an additional $10 billion in taxes during this time.

I am not a tax expert, so I will not bother to opine whether a statutory rate of 20% is better than one of 35% in terms of competitiveness. I know that the global average rate is around the 20% mark and that most OECD countries have additional Value Added Taxes (VAT) which serves as an additional source of government funding.

When the “Tax Reform” bill went through, I thought it was a sensible idea – rather than having corporations jump through hoops to get to a 20% effective rate, just simplify the system to charge 20%.

While simplification is a sensible idea, it is not the actual idea that was passed into law. I discovered that rather than reforming the Byzantine tax structure, the 2017 bill simply kept the convoluted structure in place while lowering the statutory rate. The 2017 tax reform act was devoid of reform, in other words.

This is the shock that I received when I looked at Union Pacific’s third quarter 2018 financials. The company generated a pre-tax profit of $5.7 billion and paid a total of $0.8 billion in cash taxes -- lowering its already low rate of 20% to a 15% effective tax rate!

So a stodgy, industrial company acting as a regulated monopolist and generating higher profits than many software firms was able to significantly boost its profits due to the changes in tax laws.

The next sensible question is whether this increase in profitability has driven an increase in investment spending – one of the main benefits of lowered tax rates trumpeted by Congressional Republicans in advance of the vote. You be the judge. Here is our estimate of UP’s investment spending over the past few years – representing money invested in its business above and beyond the capex it needs to maintain its infrastructure ("Expansionary Cash Flow").

Figure 2. Source: Company Statements, Framework Investing Analysis

FrameworkInvesting.com

Not much bang for the bucks lost in "tax reform," at least as far as Union Pacific is concerned.